ISDA Takes Aim at ESMA Non-Equity Transparency Proposals

In comments responding to a consultation paper released by the European Securities and Markets Authority (ESMA), the International Swaps and Derivatives Association (ISDA) has called for “targeted amendments” to the MiFIR transparency framework for derivatives, adding it believes that “the main obstacle to meaningful transparency relates to a few misconceptions with respect to transparency in derivatives markets”.

In direct response to ESMA’s proposals on the “equitisation” of regulations, the association says, “ISDA believes that it is counterproductive to assume that concepts from equity markets regulation should be used for the purpose of derivatives regulation. One simple example is the use of ISINs for the identification of derivatives. Another example is the meaning of liquidity in derivatives, which differs significantly from equity or bond markets, as there is neither a finite pool of liquidity nor a single ‘issuer’ of financial instruments in derivatives markets.”

It also argues that the non-equity instruments buckets in the inadequately appropriate, adding, “With respect to the structure of MiFIR transparency requirements, i.e. equity vs non-equity instruments, we highlight that bond markets are different from derivatives markets, in terms of objectives, market structure and the above-mentioned notion of liquidity. Furthermore, the differentiation between exchange-traded derivatives (ETDs) and OTC derivatives is sometimes not granular enough. ISDA is of the view that within the ‘non-equity’ bucket, ESMA should recognise the structural differences between fixed income markets and derivatives markets.”

ISDA also highlights the different role systematic internalisers (Sis) have in derivatives markets, observing that unlike trading venues such as MTFs and OTFs, SIs interact with their own clients to agree bespoke OTC derivatives products on a principal-client basis. It also points out that, the pricing of OTC derivatives largely depends on counterparty risk and contractual relationships with respect to clearing houses and collateral agreements.

ISDA stresses that it members maintain the view that the review of MIFID II/MIFIR should lead to meaningful transparency and useful information provided to end-users on the dynamics in derivatives markets. “We have noted the willingness of ESMA to call for simplification of the regime in various review reports,” it states. “By simplification, however, ESMA means more alignment between the securities and derivatives regimes and between OTC products and exchanged- traded products.

“ISDA members are very concerned that this approach, rather than simplifying MIFID II/MIFIR, would disincentivise corporates, buy-side firms and generally all end-users of derivatives to appropriately hedge the risks that they are facing in the course of their business with tailored derivatives instruments in the EU,” it adds.

Market impact and information leakage are also raised by ISDA in its response, which notes that for corporates in particular, transparency on large transactions or on transactions referring to an illiquid underlying can distort the price formation process to the detriment of the end-user.

If the transaction is split up into smaller buckets (which is a common practice for larger and/or illiquid transactions), ISDA warns that hedging transactions done at a later stage will become “significantly more expensive”. It also observes that pre-trade transparency when creating bespoke instruments then makes it easier to attribute multiple smaller transactions to the same end-user, “potentially encouraging predatory behaviour to the detriment of end-users”, and adds, “Both end-users of derivatives and financial institutions providing hedging solutions face undue risk as a result of pre-trade transparency in this context. As such, the suppression of the SSTI threshold would be detrimental to the EU markets and EU end-users of derivatives.”

On the subject of central clearing, ISDA says one of the reasons for the success of central clearing of derivatives is that the level of standardisation required to make an instrument clearable does not prevent counterparties from customising a contract to match it with the hedging needs of the end-user. “The need for customisation expressed by end-users justifies a cautious approach to transparency,” it argues.

“With all these considerations in mind and with respect to RTS 2, ISDA members believe that it is fundamental – before amending the scope of the transparency regime or the calibration of the thresholds – to remedy the fundamental flaw of the regime which is the use of ISINs for derivatives products,” the response states. “ISDA continues to believe that the use of ISINs for derivatives undermines reference data and transparency information due to a) an exponentially increasing number of ISINs for derivatives, adding little value and b) the fact that heterogenous derivative contracts with significant differences may share the same ISIN code, while in other instances, homogenous contracts with similar features concluded on several days would be likely to receive different ISINs.

“The inadequacy of pre-trade and post-trade transparency implemented through use of ISINs is illustrated by the fact that OTC derivatives with the same ISIN often have very different prices,” it adds.

Urging ESMA to address this issue, ISDA argues the transparency regime applied to derivatives will not be meaningful, nor will it add any value for end-users and investors as long as ISINs are used for the identification of derivatives. “A qualitative review of transparency and data quality issues should be at the heart of the review,” it states.

While appreciating that ESMA is reviewing the existing calibration of the two existing thresholds and not wanting to pre-empt future level 1 changes, ISDA also observes that ESMA is proposing, in review reports on MIFID II/ MIFIR, to merge the LIS and SSTI thresholds, i.e. that only one threshold applies (which would represent a significant change). “ISDA members believe these approaches are inconsistent,” it states. “ISDA members are concerned about engaging in a long and costly recalibration of the existing thresholds if ESMA intends to completely remove one of them completely in the near future. We are concerned about the prospect of an initial operational change consisting in reviewing the current two thresholds being quickly followed by a second major operational change in the form of the potential suppression of one of these two thresholds.”

In conclusion, ISDA says its members oppose a major overhaul of RTS 2 “at this premature stage”, observing that the regime has only been applicable since January 2018 and the SI regime has only been in place since September 2020. It adds that it believes the current waiver regime should be maintained.